THE Supreme Court of Appeal delivered judgment last month in the case of Founders Hill (Pty) Ltd v the Commissioner for the South African Revenue Service which dealt with the capital versus revenue nature of proceeds received by a realisation company that acquires land in order to dispose of it.
The leading commentators on tax in SA have expressed the opinion previously that when a company acquires an asset with the purpose of reselling it the proceeds so realised constitutes income liable to tax, with the only exception relating to socalled realisation companies, which are not created in order to dispose of assets as part and parcel of a scheme of profit-making.
In Founders Hill, the company was created for the purpose of realising land formerly owned as a capital asset by its holding company, namely AECI Limited. When a company is referred to as a realisation company it means an entity that has been created to facilitate the disposal of property, and the company does no more than to realise the asset owned by it.
Left: SARS argues company crossed the tax Rubicon: capital vs revenue nature of the proceeds of company's land that was sold for a profit was at issue and the Tax Court...held that...the surpluses realised on the disposal of land was capital in nature.
In the Founders Hill case, SARS contended that the company had crossed the Rubicon when it sold the land on which it realised surpluses. The company on the other hand argued that it had merely realised a capital asset to its best advantage and that the proceeds constituted a receipt of a capital nature and that no tax was payable on the basis that the proceeds were realised prior to the introduction of capital gains tax.
The court took the view that Founders Hill had acquired the property from AECI for the purpose of developing the land and reselling it. Originally, the Commissioner did not assess Founders Hill to tax on the profits made on the land disposed of. However, it subsequently issued revised assessments subjecting those profits to tax.
Founders Hill objected to the assessments issued to it on the basis that the proceeds of the sales were capital in nature and proceeded on appeal to the Tax Court once the Commissioner disallowed its objection. The Tax Court upheld the appeal lodged by Founders Hill.
The Tax Court held that Founders Hill had acquired the land as a capital asset and that it did not change its nature by the time that it was sold and therefore the capital gain realised was not taxable.
AECI Limited had owned the land in excess of its requirements for some time and in 1989 it was recommended that a strategic plan, which had been developed, be accepted, namely that AECI makes the decision to sell or develop the land and commences the process to do so. As a result of this decision Founders Hill (Pty) Ltd was created as a subsidiary of AECI to acquire the land from AECI and to realise that land to best advantage.
Founders Hill itself had no employees and its sole shareholder was AECI and its directors were those of AECI. The land located at Founders View was subdivided and developed by AECI before being transferred to Founders Hill and the profits accrued to Founders Hill. Founders Hill argued that it always intended to realise the land held by it as a capital asset and submitted that it was entitled to realise an asset to best advantage. The court was required to determine whether Founders Hill realised the land owned by it to best advantage or whether it embarked upon the business of selling land.
In Founders Hill the Commissioner argued that the company had crossed the Rubicon and therefore any surpluses realised on the disposal of the land owned by it constituted income liable to tax. The Tax Court, however, held that the Rubicon had not been crossed and that the surpluses realised on the disposal of land was capital in nature.
Judge Lewis, in the Supreme Court of Appeal, pointed out that Founders Hill was created as a “realisation company” on legal advice and that by acquiring the land from AECI and realising same to best advantage it should not cross the Rubicon. The judgment contains an analysis of the tax treatment of realisation entities and particularly the decision of the Court in Berea West Estates (Pty) Ltd v Secretary for Inland Revenue. In that case, the profit realised on the disposal of land by a company formed for the purpose of realising land held by different family members was held to be capital in nature. Judge Lewis noted that an interposed realisation company will be treated as holding assets acquired by it as capital assets from the seller in special circumstances as set out in Berea West’s case and not merely where the realisation company acquires property for the avowed purpose of disposing of same at a profit.
It was pointed out by the court that the fact that Founders Hill said that it had acquired the properties from AECI as capital assets did not mean that they were in fact capital assets for tax purposes. Founders Hill was created to develop the land owned by it and to sell it. The court therefore held that the surpluses realised by Founders Hill on the disposal of the land represented profits made as part of a scheme of profit-making and therefore revenue derived from capital productively employed and was therefore liable to tax. Judge Lewis held that Founders Hill had acquired the land from AECI as stock in trade and then conducted the business of trading in that property, and that the surpluses realised were taxable as income. The court confirmed the Commissioner’s assessments issued for the years in question.
The court was also required to consider the imposition of interest on the underpayment of provisional tax in terms of section 89quat of the act. The court referred to the fact that Founders Hill had acted on legal advice and in the mistaken belief that the disposal of its property as a capital asset as a realisation company should not give rise to the imposition of penalty interest on the underpayment of provisional tax. Therefore, the court directed that the Commissioner must waive the interest levied on the underpayment of provisional tax. Unfortunately, the provisions of section 89quat have been amended such that the Commissioner’s discretion to waive the interest on the underpayment of provisional tax has been narrowed significantly.
It was pointed out above that the Founders Hill case dealt with a tax dispute that arose before the introduction of capital gains tax in SA. When capital gains tax was introduced during 2001 amendments were introduced to the law to cater for the situation where assets held by a person as a capital asset become trading stock. Therefore had capital gains tax been in force at the time that AECI Limited proposed to deal in the land owned by it, it may have been possible for AECI Limited to argue that a certain of portion of the value attributable to the fixed property constituted an amount of a capital nature subject to capital gains tax and not income tax by virtue of the provisions contained in paragraph 12 of the Eighth Schedule to the Act.
Dr Beric Croome is a tax executive at ENS. This article first appeared in Business Day "Business Law & Tax Review" June 2011. Free Image from ClipArt.